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Basel III – an overview of the new banking and liquidity requirements

On 12 September 2010, the Basel Committee on Banking Supervision (BCBS), following a period of consultation with the banking sector, agreed increases in capital and new liquidity requirements for banks. The new global standards will be more prescriptive concerning the type of capital that banks will be required to maintain in future and the new liquidity standards will specify the types of assets that banks must hold to meet cash flow and collateral needs efficiently.

The requirements for banks to hold more and better capital and to hold a minimum of assets in highly liquid form, such as government bonds, will inevitably mean a reduction in the capacity of banks to lend at all levels of the market.

We expect to see banks continue the process of the last 18 months in deciding which of their existing borrowers they will refinance (in many cases only partially) and which (limited number of) new borrowers they will admit to the shrinking pool of recipients of their capital. As a result of this process there will be borrowers who will lose the support of their bank and the hunt for debt will become a serious challenge.

Bank capital and liquidity

It is no exaggeration to say that the global banking sector remains in a fragile state. Under the close attention of regulators, banks have spent the past 18 months or more replenishing their capital. In December 2009, propelled by the financial crisis, BCBS approved for consultation a package of proposals to strengthen global capital and liquidity regulations, known now as Basel III. Just under a year later, a record by the standards of previous incarnations of bank capital regulation, the new global standards have were issued for consideration following the G20 meeting in Seoul in November 2010.

BCBS has overseen two earlier bank capital accords – Basel I and Basel II – establishing rules for coordinating the capital adequacy of internationally active banks. The capital adequacy rules were intended to ensure that banks had a sufficient cushion to absorb financial blows and continue in business, lending to individuals and companies and not contaminating the wider economy. Neither Basel II nor the governments and regulators implementing it envisaged a financial crisis on the scale of what happened during 2007 and 2008.

The approach under Basel II which required banks to allocate capital to assets which are risk-adjusted has been criticised for reinforcing the pro-cyclicality of the banking system. Banks operate according to risk-sensitive capital requirements, and are, as a result, less able to lend in a recession and more willing to lend in a boom, because risk-sensitive capital requirements decrease when the estimates of default risk are lower (boom) and increase when the estimates of default risk are higher (bust). In the Treasury’s report ‘Banking Crisis: regulation and supervision’ in July 2009 it was stated that there is a strong argument in favour of the introduction of counter-cyclicality in capital regulation. Banks would be forced to build up capital reserves in the good years which would then be available for the inevitable years of economic decline that follow. By slowing down credit growth in a boom, counter-cyclical capital rules should also provide the counterbalance to the financial markets’ fuelling of asset class bubbles.

Basel III

Once approved by G20, national governments will be required to implement the new regulations. Within the European Union, this will be driven at European level through a change to the Capital Requirements Directive.

Basel III covers the following key points:

Capital Base – Improved quality, consistency and transparency of the capital base. Common equity (core capital) making up Tier 1 capital (the highest-quality party of a bank’s capital) will be a larger component of the capital base. Tier 1 capital will comprise qualifying financial instruments based on much stricter criteria. The current capital ratios under Basel II are two per cent for common equity and four per cent for Tier 1 capital (applying the Basel III definition of core capital these figures are closer to one per cent and two per cent respectively). These will change under Basel III to 4.5 per cent common equity and an increase in the Tier 1 capital requirement to six per cent. The new regime for core Tier 1 capital is very significant. Some banks will need to issue further equity in order to achieve the required core Tier 1 capital. The new rules are intended to ensure that the banking system is in a better position to absorb losses on both a going concern and a gone concern basis. The changes will be phased in over a period commencing 2013, ending 2015.

Capital Conservation Buffer – BSBS has proposed a 2.5 per cent buffer above the regulatory minimum requirement should be met with common equity. It will be phased in between 1 January 2016 and 31 December 2018 to be fully effective from 1 January 2019.

Liquidity Coverage Ratio (LCR) – Global minimum liquidity standard. Basel III introduces a global minimum liquidity standard for internationally active banks to ensure that they maintain an adequate level of unencumbered, high quality assets that can be converted into cash to meet its short-term liquidity needs. The framework also includes a common set of monitoring metrics to assist supervisors in identifying and analysing liquidity risk trends at both the bank and system wide level. The new liquidity coverage ratio aims to ensure adequate liquidity in the event of another market dislocation. The supply constraints of deposits, funding and high-quality liquid assets could be a larger problem for some institutions than the significant increases in capital. The liquidity coverage ratio will be introduced on 1 January 2015 after an observation period beginning in 2011.

Net Stable Funding Ratio – Hand in hand with the LCR this ratio is designed to promote resilience over longer-term time horizons by incentivising banks to fund activities with more stable sources of funding. At the beginning of the financial crisis some banks found that short-term credit lines were not renewed which compromised their ability to meet maturing payment obligations. The ratio is of the longer-term sources of funding employed by an institution relative to the liquidity profiles of the assets funded and the potential for calls on liquidity funding arising from off-balance sheet commitments and obligations. The detail has yet to be finalised and will be implemented during an observation phase before being introduced as a minimum standard by 1 January 2018.

Leverage Ratio - Leverage ratio to supplement the Basel II risk-based framework. The leverage ratio will help contain the build-up of excessive leverage in the banking system and is intended to supplement the capital requirements. The Bank supervisors and regulators will test a minimum Tier 1 leverage ratio of three per cent of gross assets (which will include certain off-balance-sheet items). To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for any remaining differences in accounting standards around the world before final adjustments in the first half of 2017 and a fully functioning part of the supervisory regime from 1 January 2018.

Countercyclical Capital Buffers – This requirement of the Basel III Standard echoes the comments in the Treasury’s report mentioned above. It introduces a series of measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress. The range will be zero per cent to 2.5 per cent of common equity or similar loss absorbing capital. These requirements have yet to be finalised. The intention is that a countercyclical capital framework will contribute to a more stable banking system, which will help dampen, instead of amplify, economic and financial shocks.

The impact for borrowers

Banks have endured a torrid time. They are under pressure to rebuild their balance sheets but at the same time to continue lending, particularly to the SME sector. Banks also have concerns over their borrowers and how they might cope with another dip into recession. To build up the capital buffers, banks will have to recycle profits and defer dividends as the markets for raising capital by rights issues are limited at the moment. Even though Basel III recognises the challenges facing banks in building up the capital base – hence the long lead-in times for the various standards – the prospect of the introduction of the standards is already having an affect on lending practices.

The cost of capital will inevitably increase and this will be passed onto borrowers. Certain lending activities will carry a higher capital cost, development finance, for example, is likely to be approached with even more caution by banks in the future. Relative to the current capital requirements under Basel II, if lending is seen as higher risk, Basel III will require an even higher allocation of capital. As most banks are now down-sizing their property loan books, the additional pressure imposed by Basel III is likely to exacerbate the shrinkage of available debt for the property sector.

Of course, this situation could encourage new entrants to the loan market, businesses without the legacy of impaired loans weighing heavily on their balance sheet. Greater competition in the banking industry is one of the objectives of the Coalition Government’s programme and this could be the thinnest silver lining in an otherwise very large, black cloud. What is clear is that there is still a great deal of uncertainty ahead for the UK’s borrowers.